With interest rates in the municipal bond market approaching the
low point in recent history, many government finance officers are being
bombarded with proposals to refund their outstanding bonds.
Unfortunately, refundings are not widely understood, although they are
widely utilized.

This article discusses current and advance refundings and explains
the mechanics of refundings. The article also focuses on the three
components of an advance refunding transaction; the refunded bonds, the
escrow account and the refunding bonds.

In a refunding issue, the proceeds of a refunding (new) issue are
used to retire a refunded (old) issue. A refunding issue is usually done
to restructure debt, to revise covenants, to realize savings or to
achieve several of these objectives. Savings result when the debt
service on the refunding issue is lower than the debt service on the
refunded issue.

On refundings motivated by debt restructuring, most financial
advisors recommend a refunding when it will avoid a default or preclude an unmanageable tax or rate increase. On refundings motivated by
covenant revision, most financial advisors recommend a refunding when it
will eliminate bond covenants which impede the issuer's ability to
construct facilities or provide services.

Due to escrow considerations and issuance costs, the refunding
issue will typically have a larger principal amount than the refunded
issue, which produces a loss from an accounting standpoint, even if the
transaction produces savings from an economic standpoint.

Current Refundings

A current refunding occurs when the (old) refunded issue is retired
within 90 days after the refunding (new) issue is sold. Proceeds of the
refunding issue are used to purchase the refunded bonds from investors
at the maturity date or at a call date prior to the maturity date.

A current refunding is less complicated and less costly than an
advance refunding, since a current refunding does not require that the
issuer establish an escrow account, hire a paying agent/registrar to
administer the escrow account, obtain bond ratings on the refunded issue
or verify the cash flow in the escrow account.

Most financial advisors will recommend that an issuer pursue a
current refunding whenever it produces savings, since the only costs
consist of the nuisance cost in the differences between the old tax law
and the new tax law and the opportunity cost in the differences between
the old call flexibility and the new call protection.

Advance Refundings

An advance refunding occurs when the refunded bonds are retired
more than 90 days after the refunding bonds are sold. Proceeds of the
refunding issue are used to buy U.S. government securities, which are
held in an escrow account until funds are needed to pay interest on the
refunded bonds and to purchase the refunded bonds from investors at the
maturity date or at a call date prior to the maturity date.

Prior to the 1986 tax reform act, an issuer could realize savings
by refunding old "low coupon" bonds with new "high
coupon" bonds. In a "low to high" advance refunding, the
"minor portion," which could equal up to 15 percent of the
original refunded issue, could be invested in the escrow account at an
unrestricted yield. Also, the refunded issue could be escrowed to the
maturity date, rather than to the call date, which maximized this legal
"arbitrage."

After 1986, an issuer can only realize savings by refunding old
"high coupon" bonds with new low coupon" bonds. In a
"high to low" advance refunding, the refunded issue is
escrowed to the call date, rather than to the maturity date. Because the
escrow account can only earn the low refunding bond rate, but must pay
the high refunded bond rate, the escrow account requires more funds,
resulting in a higher issue size, further resulting in a lower savings
level.

Since the Tax Reform Act of 1986 imposed severe restrictions on
advance refundings, there is an opportunity cost associated with these
financings. The act imposed restrictions on interest earnings, limited
the number of times that an issue can be advance refunded, prescribed rules for calling bonds prior to maturity, prohibited issuers from
advance refunding private activity bonds, and stiffened the transferred
proceeds penalty (described later in this article).

The act permits bonds issued after 1985 to be advance refunded only
once. Also, the act requires that bonds called in an advance refunding
which produces savings be called at the first date on which they can be
redeemed at a call premium of 3 percent or less. Further, the act
specifically prohibits several types of "abusive"
transactions.

Refunding savings are sensitive both to changes in the level of
interest rates and to changes in the shape of the yield curve, which
depicts the difference between short-term rates and long-term rates. In
most cases, an economical refunding will require at least a 200 basis
point (2.00 percent) difference between the old bond rates and the new
bond rates, on a maturity-by-maturity basis.

Generally, the savings in a "high to low" refunding
solely result when the issuer "saves" the interest between the
call date and the maturity date. Most financial advisors will recommend
that an issuer pursue an advance refunding whenever it produces savings
above a predetermined threshold, such as present value savings equal to
4 percent or 5 percent of the par amount of the refunded bonds, because
of the issuance cost and opportunity cost associated with an advance
refunding.

Most refunding analyses present the refunded debt service to
maturity (which is used for comparison purposes to illustrate savings),
the refunded debt service to call (which is used to illustrate the
escrow account requirements), the escrow account investments and the
escrow account yield (which is used to illustrate the yield
restriction), the sources and uses of funds (which is used to illustrate
the refunding issue sizing), and the refunding debt service.

The opportunity to realize savings through an advance refunding is
determined by the interest rate on the refunded bonds, the interest rate
on the escrow account and the interest rate on the refunding bonds.

Refunded Bonds

The opportunity to realize savings through an advance refunding is
determined by the nature, size and structure of the refunded bond issue.

The call feature can increase the likelihood of an economical
advance refunding. Because the earnings rate cannot exceed the borrowing
rate on the refunding issue, it is only economical to refund bonds that
can be called. If the call date is many years earlier than the maturity
date, an advance refunding will produce more savings.

The issue size also can increase the likelihood of an economical
advance refunding. Because many of the issuance costs associated with a
bond issue are not directly related to the size of the issue, an advance
refunding of a large bond issue will produce relatively more savings
than an advance refunding of a small bond issue.

The issue purpose also can increase the likelihood of an economical
advance refunding. Generally, an advance refunding of a prior "new
money" issue will produce more savings than an advance refunding of
a prior advance refunding issue, since the latter must reflect the
"transferred proceeds" penalty.

The transferred proceeds penalty is designed to prevent issuers
from issuing "high coupon" first refunding bonds and
capitalizing the escrow at the high rate, then issuing "low
coupon" second refunding bonds and recapitalizing the escrow at the
low rate. The present value difference between the escrow cash flow
discounted at the high first refunding rate and at the low second
refunding rate is subtracted from the target figure in the escrow
internal rate of return (IRR) calculation, artificially increasing the
escrow yield and decreasing the savings on a dollar-for-dollar basis.

Finally, the maturity schedule can increase the likelihood of an
economical advance refunding. Because savings are realized when bonds
are called in advance of maturity, an advance refunding of an issue with
a long maturity will produce more savings than an advance refunding of
an issue with a short maturity.

Savings also are determined by the particular issues and maturities
that are being refunded. Generally, by adding or deleting issues and/or
maturities, an issuer can create a larger, but less efficient, financing
or a smaller, but more efficient, financing.

Escrow Account. The opportunity to realize savings through an
advance refunding also is determined by the escrow account.

The yield on the escrow account cannot be greater than the yield on
the refunding bonds. Changes in the spreads between the government and
municipal markets and the slopes of the two yield curves can create
refunding opportunities. Generally, a narrow spread between the
government and municipal markets, a flat government yield curve, and an
upward-sloping municipal yield curve offer the most attractive
conditions for an economical refunding.

"Arbitrage" refers to a price discrepancy between
markets. In an escrow account, positive arbitrage exists when the escrow
yield is greater than the bond yield, requiring the issuer to suppress
the escrow yields by buying lower-yielding escrow securities. Likewise,
negative arbitrage exists when the escrow yield is less than the bond
yield, encouraging the issuer to stretch the escrow yield by buying
higher-yielding escrow securities.

An escrow account also can experience inefficiency. In the ideal
situation, an issuer will purchase escrow securities that mature and/or
pay interest on the same dates as the refunded bonds mature and/or pay
interest. When this is not possible, the escrow receipts which are
uninvested between the escrow payment dates and the refunded bond
payment dates create the inefficiency.

State and Local Government Series (SLGS) securities are U.S.
government securities which are available in amounts, dates and rates to
accommodate the yield restriction that might be required and to
eliminate any inefficiency in municipal bond escrow accounts. The
government publishes maximum SLGS rates each day and permits the issuer
to subscribe for SLGS for the amounts and maturity dates required at a
rate up to the maximum rate.

Because of the economy and flexibility that SLGS offer, SLGS are
typically the preferred escrow investment strategy in instances where
the SLGS rates will permit the escrow to be invested at a rate equal to
the bond yield.

Otherwise, an issuer may purchase U.S. government securities in the
open market. However, even if open market rates are higher than SLGS
rates, it may not be possible to purchase open market securities in the
amounts, dates and rates required without creating inefficiency in the
escrow account. Further, some underwriters have made substantial amounts
of money from the brokerage fees associated with open market purchases
in the escrow account.

Refunding Bonds. Advance refunding bonds often are sold through a
negotiated sale, because of the complexities of the transaction. In an
advance refunding, the refunding bond maturities will impact the
refunding bond rate, which will impact the escrow account rate, which
will impact the amount that must be placed in the escrow account, which
will impact the original refunding bond maturities.

Because advance refunding bonds often are sold at negotiated sale,
the issue may contain term bonds, as well as serial bonds, particularly
with a relatively flat municipal yield curve. A serial bond issue has
several stated maturities, whereas a term bond issue has a single stated
maturity. The latter may be sold with mandatory sinking fund provisions,
whereby a specified amount of term bonds are "called"
according to a specified schedule.

The refunding debt service often can be structured in different
ways to produce front-end savings, level savings or structured savings.
Most financial advisors consider the present value of savings,
discounted at the refunding bond rate, recognizing that a dollar in the
present is worth more than a dollar in the future. Present value savings
will not vary much with differences in savings patterns, but gross
savings will be lower for a front-end savings pattern and higher for a
back-end savings pattern.

Often, it is necessary to sell refunding bonds with premiums. In
Texas for example, issuers such as counties, independent school
districts and municipal utility districts have a constitutional
requirement that the refunding bonds' par amount not exceed the
refunded bonds' par amount. In these situations, the issuer
typically derives some proceeds from premiums paid, rather than
principal.

For example, if the yield on a 10-year "Aaa" insured bond is 6.00 percent, the bonds can be sold with an above-market coupon of
6.50 percent for an above-par price of 103.79, producing a market yield
of 6.00 percent. The amount of the price which is above par (103.79
minus 100.00) is the premium, which equals $37,900 on a $1 million bond
in this example.

Because many investors, particularly individual investors, prefer
not to pay a price above par, premium often is generated with capital
appreciation bonds (CABs), rather than current coupon bonds. When the
premium is generated with CABs, the investor does not have to pay a
price above par, because the premium is generated by the
"nominal" yield on the bonds.

CABs, also known as compound interest bonds or zero-coupon bonds,
sell at a discounted value and mature at face value, providing a market
yield. The bonds do not pay periodic interest, although the accretion,
which is the difference between the initial value and the maturing
value, can be considered either accreted principal or compounded
interest.

For example, if the yield on a 10-year "Aaa" rated CAB is
6.50 percent, the bonds can be sold with a coupon of 0.00 percent, an
above-market (nominal) yield of 7.27 percent for a nominal price of
48.951, and a market (actual) yield of 6.50 percent for an actual price
of 52.747. The amount of the price at the actual yield which is above
the price at the nominal yield (52.747 minus 48.951) is the premium,
which is $37,960 on a $1 million bond in this example.

As it is often necessary to sell refunding bonds with premiums, it
often is desirable to sell refunding bonds with discounts. An
underwriters discount is one type of discount, whereby the
underwriter's profit or spread is deducted from the principal,
rather than generated in a premium. Because many investors prefer not to
pay a price above par, underwriters may prefer to be paid from the
principal.

An original issue discount (OID) is another type of discount,
which can offer tax advantages to the investor, yield advantages to the
issuer and market protection to the underwriter. When a bond is
originally issued at a price below par, the difference between the price
and the par value is the OID. The capital gain arising from an OID is
not taxable, whereas the capital gain arising from a market discount is
taxable, even if the gain is associated with a tax-exempt bond.

OID can produce lower yields for the issuer. On the other hand,
because the discount is typically financed in the refunding issue, OID
can also produce higher debt service for the issuer. Most financial
advisors will scrutinize the structure of an advance refunding, to
ensure that any discounts or premiums are properly applied.

The municipal market continues to develop derivative products and
innovative techniques to accommodate the constraints of the tax reform
act. In the area of advance refundings, several ideas have been
successfully tested, including delayed settlements (where settlement on
a fixed rate refunding issue is delayed to facilitate a current
refunding), forward swaps (where a future variable rate current
refunding issue is combined with a forward interest rate swap) and
tender offers (where a current refunding issue is undertaken with
bondholder consent).

Given current market conditions and recent industry developments,
it is increasingly important for government officials to understand
current and advance refundings. A basic knowledge of the mechanics of
refundings will enable a finance officer to ensure that refunding
transactions are undertaken at the lowest possible interest cost and
issuance cost, maximizing the associated benefits to the community and
its citizens.

Larry Jordan is vice president, First Southwest Company, an
investment banking firm located in Dallas, Texas. This article was
published in the January 1992 issue of the Newsletter of the Government
Finance Officers Association of Texas.

COPYRIGHT 1992 Government Finance Officers Association
No portion of this article can be reproduced without the express written permission from the copyright holder.